The ratio of stock market capitalization to GDP – the so-called Buffett indicator — measures the scale of the stock markets relative to the economy. Since the expansion of the company sector is dependent upon economic growth, the 2 inputs of the indicator are expected to develop synchronously in the long run.
So what’s the trend within the United States?
The development of the Buffett Indicator over the past 50 years has two key features:
1. A rising trend
The curve shows a comparatively continuous upward trend, even though it has shown a major acceleration lately. What explains this behavior? The growth of the private sector relative to the economy might be one among the causes. This is because of the proven fact that the federal government’s contribution to GDP has been step by step declining over the past half century.
Ratio of stock market capitalization to GDP within the USA
Notes: Q3 2020 GDP is used as a proxy for 2020 GDP; the Wilshire 5000 Index is used as a proxy for the general stock market.
US stock market capitalization in comparison with nominal GDP, in billion USD
The growth in the cash supply has also driven this acceleration. The US Federal Reserve has been cutting rates of interest repeatedly for the reason that early Nineteen Eighties, and the additional currency that this pumped into the system has boosted the stock market. With the outbreak of the worldwide financial crisis in 2007, the Fed introduced its quantitative easing (QE) program. After that, the expansion in stock market capitalization far exceeded that of GDP. In other words, QE has helped the stock markets greater than the economy.
US stock market capitalization in comparison with money supply in billion USD
2. Periods with strong highs and lows
The curve shows 4 cases of sharp peaks within the last half century. Each of the primary three cases was preceded by a burst stock bubble and a recession before reaching the underside:
- 1972–1974: The Buffett Indicator peaked at 0.85x in 1972 after which fell until 1974. This corresponds to the recession of 1973–1975, which was partly because of the primary oil price shock and the stock market crash of 1973–1974.
- 1999–2002: The market capitalization to GDP ratio peaked at 1.43 in 1999 after which declined until it bottomed out in 2002. What happened? The dot-com bubble burst and the economy fell into recession in 2001. The stock market peaked in 2000 and didn’t bottom out until 2002. By that point, the Fed had already drastically cut rates of interest, which helped revive the economy and in addition contributed to the creation of a housing bubble.
- 2007–2008: The Buffett Indicator peaked at 1.03 in 2007 before falling to its lowest point in 2008 amid the worldwide financial crisis and recession of 2007-2009. The stock market peaked in 2007 and only began to get better in 2009 when the Fed’s QE program began to take effect.
Today we’re in the course of the fourth summit. The only query is when it would reach its summit and begin descending.
Current deviation from the trend
The market capitalization of stocks skyrocketed relative to nominal GDP after QE began in 2009. The current round of COVID-19-induced QE has widened this divergence even further. The Buffett Indicator entered overpriced territory in 2013 when it crossed the 1.0x line. This effectively meant that publicly traded corporations were value greater than total economic output. Or that the market expected extremely high economic growth for the subsequent few years.
At the top of 2020, the market capitalization to GDP ratio was around 1.86, meaning that listed corporations are actually almost twice the scale of the economy. The current mismatch between stock market capitalization and GDP is the very best and longest-lasting within the last 50 years.
expectations
Every time market capitalization has deviated this removed from GDP, it has recovered just as quickly. So if history is any guide, we are able to expect a rapid decline in equity markets. While nobody can predict the height, potential triggers of a downturn could include surprise policy moves by Joseph Biden’s administration, renewed Fed tapering, worsening COVID-19 developments, or a worldwide economic slowdown.
Finding the proper time to enter the market is at all times a futile exercise, however the Buffett indicator is flashing red and has been for a while, so caution is suggested.
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Photo credit: ©Getty Images / Ioannis Tsotras
